Minyan Mailbag: Convertible Bonds
Note: Our goal in Minyanville is to remove intimidation from the financial markets and encourage an interactive dialogue among the Minyanship. We share this next column with that very intent.
I think the 'Ville would enjoy a better explanation of how the convertible bond funds have lost money. In the buzz yesterday, you said, "The market, if you want to call it that, is down substantially since January."
Many Minyans will probably assume you are talking about the stock market. I am assuming you are talking about the convertible bond market.
If I have followed this whole conversation so far, these funds buy the convertible bonds, sell the stock, and buy credit insurance. In general, I would guess they are losing on the bonds, making money on the short stock and losing insurance premium. But this is just my guess and not a good one. If the convertible bonds are getting hit that hard, why wouldn't the regular corporate bond market be getting hit harder than it is? So where are the losses coming from?
Convertible bonds are a unique subset of the corporate bond market. The notional value of all U.S. convertible bonds is roughly $300 billion, only about 7% of the total corporate bond market.
Convertible bond performance over the last several years has been driven by a process typical of "bubble" creation.
First, convertible bonds at a price offer an opportunity to "arbitrage" the various components that produce a relatively good return for risk. Smart market participants (the few convertible bond managers that exist) take advantage of these prices (price is the key here) and produce good returns. These good returns attract more capital, which causes the creation of new hedge funds (with marginally less talent) that enter the market and chase prices up. The process of chasing prices up causes more good returns and attracts more capital. This process continues, producing steady returns even though prices are no longer "cheap." As convertible bond prices (the basis as you describe it) increase, the risk increases exponentially while still producing returns. The risk is hidden.
Prices reach a point where a few "smarter" participants begin to exit the market. As they begin to exit, the market suddenly realizes that there is not enough liquidity for this exodus and prices collapse.
So it really is a Ponzi scheme at its extreme, just like any other bubble (the above process can be applied to any market).
Because convertible bonds are mostly controlled by a separate class of managers and this market is relatively small compared to the total corporate bond market, prices can collapse from the exodus described above without hurting the larger market. Convertible bond prices have collapsed without any significant widening of credit spreads and without stock prices going down.
At some point regular corporate bond managers will step in to buy because of the value being created by collapsing prices. Either that or credit spreads will begin to widen, thus hurting normal corporate bonds with convertible bonds not declining as much from that point. Either way, the fundamentals of the two markets must begin to align over longer periods.
If credit spreads do not widen, just when do regular corporate bond managers step in and start buying, I do not know; it may be happening as we speak. But this buying is offset by continued liquidation by over-invested and over-leveraged hedge funds. When the two reach equilibrium I just don't know; my guess is that this has a way to go before prices begin to increase.
The information on this website solely reflects the analysis of or opinion about the performance of securities and financial markets by the writers whose articles appear on the site. The views expressed by the writers are not necessarily the views of Minyanville Media, Inc. or members of its management. Nothing contained on the website is intended to constitute a recommendation or advice addressed to an individual investor or category of investors to purchase, sell or hold any security, or to take any action with respect to the prospective movement of the securities markets or to solicit the purchase or sale of any security. Any investment decisions must be made by the reader either individually or in consultation with his or her investment professional. Minyanville writers and staff may trade or hold positions in securities that are discussed in articles appearing on the website. Writers of articles are required to disclose whether they have a position in any stock or fund discussed in an article, but are not permitted to disclose the size or direction of the position. Nothing on this website is intended to solicit business of any kind for a writer's business or fund. Minyanville management and staff as well as contributing writers will not respond to emails or other communications requesting investment advice.
Copyright 2011 Minyanville Media, Inc. All Rights Reserved.
Daily Recap Newsletter